Academic journal article Journal of Small Business Management

The Advantages and Disadvantages of ESOP's: A Long-Range Analysis

Academic journal article Journal of Small Business Management

The Advantages and Disadvantages of ESOP's: A Long-Range Analysis

Article excerpt


An ESOP, or Employee Stock Ownership Plan, is a qualified retirement plan which can be used to provide employee stock ownership and, at the same time, advance a number of other objectives. While this article gives a thorough review of the financial advantages of ESOP's, it also explores their disadvantages. Because the advantages of ESOP's are so immediately obvious, it is important that management also be conversant with their hidden problems. It is reasonable to think that virtually every business in the U.S. is a potential candidate for an ESOP structuring. ESOP's currently cover over 10 million workers, and the participants range from small, privately held companies to Fortune 500 firms such as Polaroid and J. C. Penny.

The basic idea behind any ESOP is that common stock (or convertible preferred stock) is distributed to the accounts of employees and eventually passed on to them at retirement or departure from the firm (assuming vesting has taken place). ESOP's represent the ultimate approach to corporate democracy. Lewis Kelso, the founder of the modern ESOP, was quoted in the August 1987 issue of the Institutional Investor as saying, "the ESOP is treated as simply an employee benefit, but is really a device to save the human race" (Rosenberg 1987). While these words are somewhat strong, they represent the sentiments of some of the truly fervent devotees to this movement (Mathews 1989).


ESOP's may be either unleveraged or leveraged in nature. With an unleveraged ESOP, the firm merely makes periodic contributions of employer stock to the ESOP or contributes cash which, in turn, is used to purchase stock. The contributions are tax deductible, and the stock eventually passes on to the employees.

The real tax benefits flow to the second form, the leveraged ESOP. The initial step is once again to set up an ESOP (appropriately administered by a qualified trustee). However, with a leveraged ESOP, stock is not directly contributed to the ESOP. The shares are acquired by the ESOP's borrowing the necessary funds from a financial institution to purchase the stock from the sponsoring company or from key stockholders of the company. To ensure the availability of lendable funds to the ESOP, the sponsoring company normally guarantees the loan from the financial institution and, furthermore, makes tax deductible contributions to the ESOP to ensure that funds are available for the orderly amortization of principal and the payment of interest. The ESOP, upon receiving these funds, uses them to repay the financial institution. The shares acquired by the ESOP are, in turn, assigned to employee accounts and distributed to employees at an appropriate future time.

Most of the comments on ESOP's in this article will be directed to leveraged ESOP's because that is where the primary tax and other financial advantages lie. Leveraged ESOP's allow the sponsoring company to acquire cash for its shares, which can be used for capital investment or other corporate purposes. However, the leveraged ESOP may also acquire the shares from retiring owners of the business in order to facilitate estate planning and to ensure the continuity of the business. In either case, borrowed funds are utilized and repaid with pretax dollars. Further, as pointed out in the popular press, ESOP's also have been used as defensive measures against unwanted corporate takeovers, to facilitate the financing of LBOs and divestitures, and as part of corporate rescue operations (Burr 1989).

In the next section, the tax advantages of ESOP's are highlighted. Since most of these advantages are on the front-end, we will then take a hard look at the caveats and potential drawbacks that can come later.


The tax benefits associated with ESOP's may be broken down into three separate categories: those accruing to the corporate sponsor, those provided to original selling stockholders, and finally those available to employee participants. …

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